Fed rasies rates and eyebrows — Wednesday, March 16, 2022
- Fed Funds overnight range increases one-quarter percent
- A new tightening cycle begins, likely lasting a year and a half
- Bond buying program has ended
- Balance sheet reduction will not begin until May at the earliest
As expected, the Federal Reserve Open Market Committee raised its target overnight funds rate by one-quarter of a percent today. The action raises the range from zero to 25 basis points (one-quarter of a percent) to between one-quarter and one-half of a percent. In practical terms, the one-quarter percent rate is the new floor for overnight rates.
The Fed’s statement recognized that energy and other price pressures are keeping inflation “elevated.” The statement also cited the war in Ukraine as a factor “likely to create additional upward pressure on inflation and weigh on economic activity.” For the first time, the pandemic was not listed as a factor. The Fed pledged “ongoing (rate) increases” to attack the highest inflation rates seen in 40 years.
Traders expected some news today about the Fed’s balance sheet plans. Recall that, in addition to lowering short-term rates to fight the pandemic impact, the Fed also resumed buying bonds to provide liquidity to the financial system. Many Fed watchers thought today the Committee would reveal a plan to reduce those bond holdings. The Committee put off this decision, likely until the May 4th meeting.
Each quarter the Committee releases its views on economic growth and statistics. In a surprise move, the members showed they believe the path of short-term rates is noticeably higher than Wall Street expected. The Committee believes that they will raise rates at every meeting this year, with interest rates ending the year between 1.75% and 2%. Before the meeting most believed rates would finish this year between 1% and 1.5%. The median rate in two years is expected to reach 2.8%. Note this projection from the members is higher than the existing thirty-year Treasury bond yield of 2.5%.
The Fed staff forecasts 2022 GDP to grow at 2.8%. This is noticeably lower than the 4% projected in December. This decline in growth forecasts suggests staff is finally taking into account the effects of inflation and renewed lockdowns in the Far East impacting trade. One projection that did not change is the year-end unemployment rate at 3.5%. The Fed recognized that our labor market remains strong. The war and its impact on Europe’s economy was cited by Chairman Powell in his press conference as a risk to the economic outlook.
Regardless of which measure one chooses, inflation is at record levels. Inflation levels have fallen sequentially over the past four decades. We have mentioned in the past that inflation, like other economic variables, runs in cycles. We believe a new inflation cycle started at least a year ago. Grain prices started moving in the fall, oil first broke out last summer. Wages and rent increases will keep inflation above its recent average, finishing this year above 4%. This is not permanent inflation, but persistent over the next few years.
Increasing interest rates hurts main street interest payers, while helping savers. Reducing the Fed’s bond holdings pulls funds from the banking system, which hurts Wall Street. The Committee will be using both tools to combat inflation. We would note that the economy was already downshifting to slower growth. But, and this is important, the 2.8% growth projected by the Fed this year is still nearly double the 1.5% growth experienced over the last decade.
The first experiment during the pandemic involved Congress sending money to citizens and the Fed supporting markets while lowering rates. Sending money to citizens added fuel to already solid demand. Meanwhile supply chains were shut down by government order. The Fed’s new experiment is whether increasing interest rates, long used to “cool” an overheating economy will now be an appropriate tool to combat supply-chain inflation. We believe the Fed has a narrow path to tread this year. The risk in our view is that if the Fed proceeds to raise rates each meeting and reduces the balance sheet too quickly, it could raise recession vulnerabilities headed into next year. Granted, at present none of our indicators are in recession territory, but we remain vigilant.
The Fed finally “gets it” – that they are late to the inflation party. We believe they should have raised rates a year ago but that is
immaterial to our portfolios today and in the future. The economy is on solid footing and labor demand remains strong. Earnings estimates for stocks are expected to rise in the coming months.
We expect interest rates to rise further in the coming months but believe most of the move has already occurred. Futures markets are projecting that when the Fed finishes raising rates over the next year and half that interest rates will not be as high as they were pre pandemic. Low rates, still accommodative monetary stance and good earnings bode well for markets down the road.
Steve Orr is the Executive Vice President and Chief Investment Officer for Texas Capital Bank Private Wealth Advisors. He holds a Bachelor of Arts in Economics from The University of Texas at Austin, a Master of Business Administration in Finance from Texas State University, and a Juris Doctor in Securities from St. Mary’s University School of Law. Follow him on Twitter here.
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